TAX AND LEGAL SECRETS OF SUCCESSFUL REAL ESTATE INVESTORS

Real estate investing has tremendous tax advantages. But to realize these advantages fully, you need to set up your real estate investing activities in the right way from the start.

Several provisions of the US tax code were written with the specific intent of encouraging real estate development and investing. The tax provisions give you the ability to shelter most, if not all, of the cash flow that your properties generate from federal and state taxation. Sometimes even wiping out some of the taxes on personal income not related to real estate.

Investing in real estate continues to be one of the best ways to build wealth and cut taxes. Benefits include the ability to recover the cost of income-producing property through depreciation, to use 1031 exchanges to defer profits from real estate investments, and to borrow against real estate equity to make additional investments or for other purposes.

The government treats real estate investing as a business, and because of this, you can deduct a wide variety of direct and indirect expenses that are associated with managing and maintaining a property. Things like repairs, utilities, office expenses, property-manager salaries, advertising, and more. You can also deduct some significant ‘phantom’ expenses like depreciation; costs that are recorded in the property’s books but that you don’t actually pay out-of-pocket.

To make the most of these tax benefits and savings, you need to have a real estate or tax accountant on your team who can help you craft a tax strategy ahead of time. This will allow you to maximize your returns and minimize your taxes legally and legitimately. Below are tax and legal secrets that successful real estate investors use and they are;

• Using Depreciation Deduction

You can recover the cost of income-producing rental property through annual tax deductions called depreciation. The Internal Revenue Code defines the depreciation deduction as a reasonable allowance for deterioration, wear, and tear, and a reasonable allowance for obsolescence.

Real estate investors generally use a depreciation method called the Modified Accelerated Cost Recovery System (MACRS), in which residential rental property and structural improvements are depreciated over 27.5 years, while appliances and other fixtures are depreciated over 15 years. Depreciation expense often results in a net loss on investment property even if the property actually produces a positive cash flow. This loss, as well as expenses, such as utilities and insurance, are reported on Schedule E, federal income tax Form 1040, and deducted from ordinary income.

• Taking Advantage of 1031 Exchanges

The 1031 exchange, named for Section 1031 of the Internal Revenue Code, allows investors to defer taxes by selling one investment property and using the equity to purchase another property or properties of equal or greater value. This exchange must occur within a specified period of time.

Although a 1031 exchange can broadly include various types of property, the vast majority of transactions relate to real estate. And from Dec. 31, 2017, onward, Section 1031 like-kind exchange treatment applies only to exchanges of real property held for use in a trade or business or for investment, other than real property held primarily for sale.

In order to successfully complete a 1031 exchange, the properties must meet the following criteria:

• The aggregate value of the replacement properties must be equal to or greater than that of the relinquished properties.
• The properties included in the transaction must be like-kind, meaning real property cannot be exchanged for some other type of asset, such as a real estate investment trust (REIT).
• Both properties must be held for “productive purposes in business or trade” (an investment).

 

• Borrowing Against Home Equity

Investors who have built up sizable equity in either their personal home or investment property may simply choose to refinance their properties and pull out equity to make additional investments, improve the home, or for other purposes. Regulations vary from state to state.

In a typical scenario, a lender will loan 80% to 85% of your equity. For instance, on a $240,000 property with a $100,000 loan, the most a borrower could extract is $112,000 ($240,000 – $100,000) x 0.80 = $112,000).

The ability to borrow against your equity will also depend on your credit score, your existing debt-to-equity ratio, and your debt-to-income ratio. While this strategy is a bit riskier, for those able to handle the additional debt, it can help build wealth without having to enter into a 1031 exchange or sell a property.

• Deferring Taxes on the Sale of a Home

Gains from the sale of a taxpayer’s primary personal residence are excluded from capital gains taxation up to $500,000 for married couples that file jointly and $250,000 for single individuals if the taxpayer has lived in the home for two of the last five years. In addition, should the gains from the sale of a taxpayer’s primary residence be greater than those exclusions, the taxpayer may also invest that portion through a 1031 exchange. Investors who live in areas where home values are appreciating can use a strategy of trading up to both build their personal wealth and minimize taxes at the same time.

• Deducting Mortgage Interest

Homeowners can deduct the portion of their mortgages attributable to interest payments on their tax returns. These payments are higher during the early years of the mortgage and gradually decrease as the mortgage is paid off.

According to the IRS, you can deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness. However, higher limitations ($1 million ($500,000 if married filing separately)) apply if you are deducting mortgage interest from indebtedness incurred before December 16, 2017.

 

As informed investors we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.